I am a long term buy and hold investor who focuses on dividend growth stocks

Wednesday, September 15, 2010

Six companies with 20% yields on cost

I often get asked by new readers about the reasoning behind my fascination with companies that have a long history of consistent dividend increases. Often readers would see how a company like Wal-Mart (WMT) has raised distributions for many years, and yet still yields 2.40%. The answer to their question is as simple as understanding yield on cost.

Before we begin with yield on cost, it is important to understand how current dividend yield is calculated. By dividing the annual dividend payment by the stock price, one gets the current dividend yield. For example Wal-Mart (WMT) trades at $49.43, and pays a dividend of $1.21/share. As a result the current dividend yield is 2.50%. Given the fact that the company has raised dividends for over 36 years however, to the novice investor this might not look like a big achievement. After all, it is easy to purchase a high yielding master limited partnership such as Kinder Morgan (KMP) and get a yield which is almost three times the amount of yield one could generate by purchasing Wal-Mart (WMT) stock.

The truth is that today’s investor will generate 2.50% dividend yield over the next year. In other words an investor who puts $100 in Wal-Mart (WMT) today will generate $2.50 in annual dividend income. As a result if the price of Wal-Mart (WMT) doubles from here, but the dividend payment remains unchanged, our investor will keep receiving $2.50 in annual dividend income, despite the fact that current yield would be 1.25%. What the current yield doesn’t tell is what the yield on cost over the next year or decade is going to be. If the price of Wal-Mart (WMT) stock doubles over the next decade, but the dividend payment doubles as well, the current yield would likely stay around 2.50% in ten years. The yield on cost of the original investor with the $100 investment would be a cool 5%. Most novice investors in ten years would likely still ignore Wal-Mart (WMT) because of its supposedly low yield, while missing the important fact that rising dividends will lead to rising yield on cost over time.

The investor who purchases stocks with yield on cost in mind will be able to generate yields on cost on his original investment that will be much higher than the current yields on even high yielding stocks such as mortgage reits American Capital Agency (AGNC) or Hatteras Financial (HTS), with just a fraction of the risk. The key component is selecting stocks with strong competitive advantages, which grow earnings and could therefore grow distributions. Last but not least, investors should also allow some time in order to generate high yields on cost. Some dividend investors prefer waiting for a decade before attaining an yield on cost of 10%. Others, myself included, simply focus on finding strong companies with long histories of dividend growth, and let yields on cost increase for the maximum periods of time possible, without setting any targets. Needless to say, purchasing high quality dividend stocks is more of an art than science. By focusing your attention on such lists as the dividend achievers or the dividend aristocrats however, dividend investors have a high chance of succeeding in their quest for growing income.

Most of the original dividend aristocrats were able to achieve substantial yields on cost for a period of 20 years. Even those that managed to freeze distributions were able to generate high yields on cost over time, in addition to generating capital gains as well.

Colgate Palmolive (CL) was deleted in the index in 1990 for no apparent reason. According to yahoo finance the company increased its distributions in 1989. In addition to that the company’s own web page claims that it has increased payments to common shareholders every year for 46 years. One dollar invested in CL in 1989 would have turned out to $16.94 with dividends reinvested. The yield on cost is 27.70%. (analysis)

Johnson & Johnson (JNJ), which recently announced its 47th consecutive annual dividend increase, is still part of the index. A dollar invested in JNJ in 1989 would have turned out to $10.84 with dividends reinvested. The yield on cost is 26.4%. (analysis)

Lowe’s Companies (LOW) is still a component of the index after 20 years. The company has increased its dividends for 47 consecutive years. A dollar invested in MAS in 1989 would have turned out to $25.40 with dividends reinvested. The yield on cost is 39%.

Procter & Gamble (PG) is one of the original 26 members still present in the index. The company has raised dividends for over 53 consecutive years. A dollar invested in PG in 1989 would have turned out to $9.05 with dividends reinvested. The yield on cost is 20%. (analysis)

Coca Cola (KO) is still a member of the dividend aristocrat’s index. The company has increased its dividends for 47 consecutive years. A dollar invested in KO in 1989 would have turned out to $7.15 with dividends reinvested. The yield on cost is 17%. (analysis)

As for Wal-Mart (WMT), investors who purchased shares 26 years ago when it became a dividend achiever received a paltry yield of 0.60% at the end of 1984. Split adjusted the shares ended $1.18 that year. The yield on cost on those investors would be over 100% today. For an investor who purchased the stock when it reached the status of a dividend champion in 1999 however, the yield was still paltry at 0.30%, but the price was steep at $69.12/share. Eleven years later their shares are yielding 1.80% on cost, while their shares are still underwater. So while a lot of money could be made with the dividend growth strategy, investors should not overpay for stocks today. (analysis)

This goes to show that a company could achieve high growth rates, while still being able to pay increasing dividends.

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